Week 4 PPOL 650 DB

Chapter 7 The Global Financial Crisis

THE GLOBAL FINANCIAL CRISIS HAD WIDESPREAD EFFECTS. In its early days in September 2008, a trader reacted to the numbers on the floor of the New York Stock Exchange as the Dow plummeted.

Learning Objectives

1. 7.1Evaluate the causes that contributed to creating the financial crisis

2. 7.2Review the impact of the global financial crisis on different world economies, business, employment, and global power shifts

3. 7.3Evaluate the concerns that made different countries respond in different ways to the financial crisis

Financial crises and accompanying economic recessions have occurred throughout history. Periodic crises appear to be part of financial systems of dominant or global powers. The United States was at the epicenter of the financial crisis of 2008–2009. Enjoying a unipolar moment following the collapse of the Soviet Union and the failure of Communism, the United States was confident that economic liberalization and the proliferation of computer and communications technologies would contribute to ever-increasing global economic growth and prosperity. Globalization contributed to the extraordinary accumulation of wealth by a relatively few individuals and created greater inequality. In an effort to reduce inequality in the United States, the government implemented policies that engendered the financial crisis.

As we discussed in  Chapter 1 ,  finance  is usually the leading force in the growth of globalization. The rise of great powers is inextricably linked to access to investments and their ability to function as leading financial centers, as we saw in  Chapter 2 . Their decline is also closely linked to financial problems. Finance enables entrepreneurs to start various enterprises and to become competitors of established companies. It is also essential to innovation and scientific discoveries. Finance also facilitates risk sharing and provides insurance for risk takers. Countries that have large financial sectors tend to grow faster, their inhabitants are generally richer, and there are more opportunities. Financial globalization contributed to unprecedented growth and prosperity around the world. China and India became significant economic powers, and the industrialized countries grew even richer. 1  Closely integrated into the financial system are banks and investment firms. When the financial system is in crisis, banks reduce lending, companies often face bankruptcy, and unemployment rises. Ultimately, as we saw in the financial crisis of 2008–2009, many banks fail.

The financial crisis triggered a global economic recession that resulted in more than $4.1 trillion in losses, saw unemployment rates that climbed to more than 10 percent in the United States and higher elsewhere, and increased poverty. Stock markets around the world crashed. American investors lost roughly 40 percent of the value of their savings. Housing prices plummeted from their record highs in 2006. Consumers reduced their spending, manufacturing declined, global trade diminished, and countries adopted protectionist measures, many turning their attention inward to focus on problems caused by the financial crisis. Given the central importance of finance to virtually all aspects of globalization, issues such as trade, the environment, crime, disease, inequality, migration, ethnic conflicts, human rights, and promotion of democracy are affected. Furthermore, the financial crisis weakened some countries more than others, thereby engendering significant shifts of power among countries, especially between the United States and China. The European Union struggled over how much to use the euro currency to shore up or bail out banks and nations. The financial, economic, social, and political fallout continues. Citizens took to the streets in a protest movement against financial inequality that began in New York City as Occupy Wall Street and spread around the world. This chapter examines the causes of the financial crisis, its impact, and responses to it. It concludes with a case study of the decline of the Celtic Tiger (Ireland).

7.1: Causes of the Global Financial Crisis

1. 7.1 Evaluate the causes that contributed to creating the financial crisis

The causes of financial crises are as complex as many of the crises themselves and the human beings responsible for them. There have been at least sixty recorded crises since the early seventeenth century. Human beings seem to have always been obsessed with money, and greed drives them to obtain increasing amounts of it. And humans generally spend more than they have, thereby creating huge debts that undermine the stability of the financial system. As early as 33 ce, Emperor Tiberius of Rome had to inject public funds into the financial system to prevent it from collapsing. 2  Euphoria and excessive optimism, which often accompany financial bubbles, are usually followed by fear and panic when crisis arrives. Generally, people claim to not know how a particular crisis happened or that they could not see it coming. The  Asian Financial Crisis  in 1997 was a precursor to the financial crisis of 2008–2009. It started in Indonesia and spread to Malaysia, South Korea, other parts of Asia, and the rest of the world. Once-prosperous economies sunk into deep recession, with stock markets crashing and capital flowing out of the various countries at unprecedented rates. The Asian crisis was largely caused by “hasty and imprudent financial liberalization, almost always under foreign pressure, allowing free international flows of short-term capital without adequate attention to the potentially potent downside of such globalization.” 3

An integral component of the struggle against terrorism was the restoration of domestic and global confidence in America’s economic system in general and its financial system in particular. President George W. Bush launched a war against terrorism. To accomplish this, the U.S. defense budget was rapidly increased, a department of Homeland Security was created, and two wars, one in Afghanistan and the other in Iraq, were launched. Furthermore, part of the new security strategy was a comprehensive globalization agenda, in which American companies operating in foreign countries would be free from restraints imposed by those countries. 4  This meant increasing government debt and encouraging consumers to spend even more to strengthen both the economy and national security. With easy access to capital created by economic globalization, consumers and the U.S. government relied on other people’s money. In addition to concentrating on fighting a perpetual war against nonstate actors, an atmosphere was created in which questioning was discouraged and taking excessive financial risks and getting rich quickly were lauded. From John C. Bogle’s perspective, at the root of the problem was a societal change. America valued form over substance, prestige over virtue, money over achievement, charisma over character, and the ephemeral over the enduring. 5  While it is almost impossible to disentangle the causes of the global financial crisis, we will concentrate on those that are most often discussed. They include (1) deregulation of financial markets; (2) sophisticated financial innovations linked to rapid changes in computer technologies; (3) excessive executive compensation; (4) low interest rates; (5) subprime loans, especially for mortgages; and (6) speculation in general, with an emphasis on speculation in housing.

7.1.1: Deregulation of Financial Markets

Just as the current financial crisis has engendered demands for reforms, the Great Depression of the 1930s led to the implementation of financial regulations to stabilize the economy and to give American savers confidence in banks. Banks were widely perceived as boring but safe. Although interest rates were low, inflation was also low. Furthermore, deposits were protected by the  Federal Deposit Insurance Corporation (FDIC) . An outgrowth of the Great Depression, rising inflation, which also occurred following rapid and dramatic increases in oil prices in 1973–1974, contributed to the erosion of confidence in regulations designed during the Great Depression. Rising inflation in the United States prompted foreigners to lose confidence in the U.S. dollar as the leading currency and to seek security by purchasing gold. In response, President Richard Nixon unlinked the dollar from gold and adopted a regimen of floating interest rates. This created greater volatility in the financial system as well as increased opportunities to earn higher interest rates. 6

Significant societal changes and developments in technology combined to serve as a catalyst to propel  deregulation . Although large banks and financial institutions initiated efforts to eliminate or modify regulations that restrained them, individuals were also more assertive in gaining control over their savings pension funds and investments in the stock market. Between 1974 and 1980, many regulations were removed. For example, in 1980, commercial banks and savings and loans institutions were permitted to determine their own interest rates on deposits and loans, thereby spurring greater competition. Many smaller banks were acquired by larger, more distant banks. The local bank was fast becoming an outdated institution. 7

Just as financial globalization drives economic globalization, the rapid growth of trade was now facilitating  global financial liberalization . Globalization in general enabled American banks to argue that they were disadvantaged in competition with British, German, Japanese, and other foreign banks that were free of restrictions faced by American banks. Moreover, American banks adopted a global outlook that freed them from limiting their operations to the United States. Many were moving their activities offshore to places such as the Cayman Islands, Bermuda, and the Bahamas. President Ronald Reagan, elected on a platform of limiting the role of government, pressured other countries to open their financial systems to American firms. Financial deregulation in the United States was now inseparable from the globalization of trade and financial services. However, impeding global competition in banking was the  Glass-Steagall Act of 1933 , which prohibited commercial banks from underwriting or marketing securities. 8  The rapid growth of capital flows across national borders and the increasing power of investment bankers eventually led to the demise of the Glass-Steagall Act in 1999.

The phenomenal proliferation of sophisticated computer technologies and an almost unquestioning faith in the wisdom of markets contributed to escalating demands for and acceptance of less regulation. In essence, federal agencies designed to regulate banking became less effective. There was a general loss of control at all levels, which led to exponential risk taking at many companies, largely hidden from public scrutiny. Violations of financial regulations went largely unpunished. 9  Simon Johnson argues that from the confluence of campaign finance, personal connections, and ideology flowed a river of deregulatory policies. These included:

1. Insistence on free movement of capital across borders

2. The repeal of Depression-era regulations separating commercial and investment banking

3. Decreased regulatory enforcement by the Securities and Exchange Commission

4. Allowing banks to measure their own riskiness

5. Failure to update regulations to keep up with the tremendous pace of financial innovations 10

7.1.2: Financial Innovations

As the global financial crisis unfolded, it was obvious that many of those in the banking and investment communities did not fully comprehend how the financial system they created functioned, or the scope and severity of the crisis. The financial wizards, the best and the brightest from leading business schools, could not really explain what was happening on Wall Street and in global financial markets. Ironically,  financial innovations , designed by brilliant computer experts to manage risk and make capital less expensive and more available, ultimately led to the global financial crisis. Financial innovations, with instantaneous global impacts due to technologies that made electronic transactions faster and less expensive, raced ahead of regulations. Complex financial products created in one financial center involved assets in another and were sold to investors in a third financial market. As we saw in  Chapter 1 , governments are increasingly challenged to operate effectively in a globalized world. Whereas governments are restrained by issues of sovereignty, global financial firms enjoy relatively greater flexibility. Furthermore, many different agencies in the United States have regulatory authority, a situation that creates confusion and ineffectiveness. 11  Among the numerous financial innovations that led to the global financial crisis were securitization and hedge funds.

Prior to the widespread use of securitization, banks, many of them local, provided loans to customers they often knew, and the banks were responsible for the risks involved in making loans. This meant that bankers gave loans only to individuals and companies they believed could repay the loans. With securitization, risks inherent in granting loans were passed from the bank giving the loans to others who had no direct interest in the customers’ ability to repay the loans. Subprime mortgages, student loans, car loans, and credit card debts were securitized.  Securitization  is a sophisticated process of financial engineering that allows global investment to be spread out and separated into multiple income streams to reduce risk. 12  It involves bundling loans into securities and selling them to investors. In 2009, an estimated $8.7 trillion of assets globally were funded by securitization. 13  This innovation made vast sums of money available to borrowers. For example, securitization increased the amount of money available to individuals purchasing homes. This led to unprecedented growth in house prices. It also resulted in high default rates and the housing crisis. As we will discuss, applicants for mortgages were not carefully examined and were encouraged to obtain subprime loans.

Another financial innovation was credit  derivatives , which were bets on the creditworthiness of a particular company, like insurance on a loan. There were two types of credit derivatives: credit default swaps and collateralized debt obligations. 14  Credit default swaps were widely used, especially by insurance companies such as the American International Group (AIG). Life insurance companies invested in credit default swaps as assets. Parties involved in a credit default swap agreed that one would pay the other if a particular borrower, a third party, could not repay its loans. Credit default swaps were used to transfer credit risks away from banks. A major problem with credit default swaps was the lack of transparency. They were also unregulated. Ultimately, credit default swaps created confusion and encouraged excessive risk taking. It was difficult to determine where the risk ended up. Designed to pass on risks, loans were packaged as securities.  Collateralized debt obligations  were linked to mortgage companies, which passed on the risk. Mortgages, instead of being held by banks and mortgage companies, were sold to investors shortly after the loans closed, and investors packaged them as securities.

Similar to securitization, hedge funds grew rapidly, accounting for more than $1.3 trillion in assets globally before the financial crisis. The name  hedge funds  implies investment funds with a particular sort of hedging strategy. Created by the Investment Company Act of 1940, hedge funds allowed wealthy investors to avoid many financial regulations, and hedge funds were early participants in financial globalization. 15  Essentially, hedge fund managers created portfolios reflecting an assessment of the performance of diverse global markets. As long as the number of participants was relatively small, hedge funds avoided great systemic risks. This changed with revolutions in computer technology that allowed split-second timing on huge volumes of trades. An integral component of the hedge fund strategy is a technique known as  arbitrage . This involves simultaneously buying at a lower price in one market and selling at a higher price in another market to make a profit on the spread between the two prices. 16

7.1.3: Executive Compensation

Excessive executive compensation is widely perceived as playing a pivotal role in creating the global financial crisis. Wall Street became a magnet for the brightest Americans who wanted to make a large amount of money very quickly. Most companies rewarded short-term performance without much regard for market fundamentals and long-term earnings. Executives were given stock options, which they could manipulate to earn more money. The more an executive could drive up his or her company’s stock price or its earnings per share, the more money he or she would get. Frank Partnoy argues that a mercenary culture developed among corporate executives. They merged with or acquired higher-growth companies and, in many cases, committed accounting fraud. 17  This fraud led to the bankruptcy of companies such as Enron, Global Crossing, and WorldCom. Many executives received long prison sentences.

7.1.4: Low Interest Rates

A fundamental cause of the global financial crisis was the easy availability of too much money globally. An oversupply of money created unprecedented levels of liquidity and historically low interest rates. As we mentioned earlier, the terrorist attacks on the United States triggered a national embrace of increased government spending as well as consumer spending. To accomplish this, the U.S. Federal Reserve, led by  Alan Greenspan , lowered interest rates to around 1 percent in late 2001. The European Central Bank and the Bank of Japan also reduced interest rates to record lows. The U.S. government encouraged Americans to purchase homes and to refinance or borrow against the value of homes they owned. As consumers and the government lived beyond their means, they were able to borrow from developing countries that were accumulating huge reserves from the phenomenal growth of global trade. Much of the surplus of money in the global system also came from declining investment in the Asian economies following the 1997 financial crisis. Rising oil prices in the Middle East, Russia, and elsewhere enabled many countries to earn more money than they could spend rationally. By the end of 2008, central banks in emerging economies held $5 trillion in reserves. 18

The money supply increased rapidly in China, India, Russia, and the Persian Gulf states. Whereas it was generally assumed that global monetary policies were set by central banks in the United States, Europe, and Japan, the reality was that three-fifths of the world’s money supply growth flowed from emerging economies. 19  Based on their experiences with financial problems, many developing countries decided to save for a rainy day, as it were. They believed that high oil prices or trade surpluses would not last forever. Many of these countries created  sovereign wealth funds  to recycle their financial surpluses.

7.1.5: Subprime Loans

Another major cause of the financial crisis was the availability of subprime loans, which were directly an outgrowth of easy credit.  Subprime loans  generally refer to credit given to individuals who fail to meet rigorous standards usually expected by lending institutions. These individuals could not really afford their loans because of inadequate income and poor credit histories. In most cases, borrowers were not required to have a down payment. With excess liquidity globally, interest rates remained low. People with weak financial histories are generally more vulnerable to being charged higher interest rates. For example, poor people pay exorbitant rates for payday loans. A basic reality of finance is that yields on loans are inversely proportional to credit quality: The stronger the borrower, the lower the yield, and vice versa. 20  Driving the demand for subprime loans was the development of a culture of entitlement and a false egalitarianism that appealed to people’s egos. Home ownership was pushed by the U.S. government as an inalienable right, despite borrowers’ inability to repay loans.  Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) , both U.S. government corporations, made more money available to lenders and borrowers by purchasing loans from the lenders and selling them to investors in the secondary markets. Huge amounts of money gravitated to subprime mortgages in the United States and Europe and, ultimately, to weak borrowers globally. Given the complex interdependence that characterizes financial globalization, problems emanating from subprime loans in the United States rapidly spread around the world. Governments were largely unaware of the risks associated with new forms of financing and were unable to prevent the global financial crisis. 21

As unprecedented sums of money flowed into commercial and residential real estate, housing prices escalated. For thirty years before the housing boom, the average American house appreciated at an average of 1.4 percent a year. This low return of prime loans discouraged homeowners from viewing their houses as cash machines. Home equity lines of credit were not available until recently. Things changed dramatically after 2000. Appreciation rates climbed to 7.6 percent between 2000 and 2006, and they reached 11 percent before the market crashed between 2006 and 2007. Real estate prices in California, Arizona, Nevada, Florida, and other areas grew even faster.

There was a wide variety of subprime mortgages. These included adjustable-rate mortgages, balloon mortgages, piggyback loans, and interest-only loans. An  adjustable-rate mortgage  is a long-term loan that does not have a fixed interest rate. The interest can be changed, with low rates at the beginning and high rates at the end. It is also possible, but highly unlikely, that rates could decline. Adjustable-rate mortgages were attractive to homebuyers who moved frequently. They were less expensive, or so it seemed, than fixed-rate mortgages, which offered more protection. A variation of the adjustable-rate mortgage is a balloon mortgage. Under this arrangement, lower payments are made on a loan for five to ten years, with a final installment, or balloon payment, that is significantly larger than earlier payments. Most borrowers could not afford to pay the balloon payment. A piggyback loan allows the homeowner to take out a second mortgage that is piggybacked onto the first mortgage. This is a high-risk loan because it clearly indicates that the borrower cannot afford the down payment to purchase real estate. 22  In an environment that encouraged consumption over savings, easy credit fueled the housing crisis. Interest-only loans required borrowers to pay the interest on a loan without reducing the principal balance. This enabled weak borrowers to obtain larger loans.

7.1.6: Speculation

A combination of low interest rates, unprecedented liquidity, and a belief that the Internet and various computer technologies virtually guaranteed unending and ever-increasing prosperity facilitated the growth of speculative financial forces. Excessive risk taking replaced caution, which was often equated with a lack of optimism.  Speculation , a deeply ingrained human characteristic, fosters the development of a herd mentality. As prices continued to rise, even the most cautious individuals get caught up in speculation. Ultimately, a speculative bubble is created. Speculative bubbles generally go through four stages:

1. A new technology or invention changes people’s expectations and those who are well informed try to profit from it.

2. Prices or profits continue to rise, which draws more people into the market.

3. The boom passes into euphoria, and rational decision making is suspended.

4. The bust is almost inevitable. Prices and profits fall, companies and individuals go bankrupt, and the economy plunges into a recession. 23

Many homeowners became speculators. In addition to low-interest loans and financial innovations in the housing market, political pressures to reduce taxes, including real estate taxes, contributed to the housing boom. Congress passed the  Taxpayer Relief Act of 1997 , which, among other things, exempted profits realized from the sale of a home if the home was owned and used as a principal residence for two of the past five years before it was sold. This new provision enabled homeowners to exclude up to $500,000 for couples and $250,000 for singles from capital gains tax. In many cases, removal of the capital gains tax encouraged home buyers to engage in a form of speculation known as flipping. The buyer would own the house for a short period with the sole intention of selling it very quickly for a higher price, thereby gaining a significant profit without much effort and by using very little of his or her own money as an investment. When the stock market crashed in 2000, real estate became more attractive to investors. Because of the huge amounts of money that went into real estate globally and the preponderance of subprime loans and excessive risk taken in home mortgages, the housing crisis was at the epicenter of the global financial crisis.

7.2: The Impact of the Global Financial Crisis

1. 7.2 Review the impact of the global financial crisis on different world economies, business, employment, and global power shifts

Housing prices crashed; foreclosures became commonplace; unemployment reached 10 percent in the United States and higher levels in Europe and elsewhere; manufacturing declined sharply, especially in the automotive industry; students were faced with higher costs as colleges suffered financial losses; finding jobs after college became more challenging; and a global recession created widespread hardships. On the other hand, many developing countries that took a prudent approach to finance and saved money were not as badly damaged. In fact, countries that did not

HOUSING WAS AT THE EPICENTER OF THE FINANCIAL CRISIS. Falling house prices directly affect government revenues, including spending for education.

fully embrace financial liberalization were less affected than those that gave in to American pressure to fully engage in financial globalization. We also saw a global power shift, with the United States losing ground to China, India, Brazil, and other developing countries.

7.2.1: Foreclosures

Plunging real estate prices affected virtually all areas of the economy. People could no longer afford to purchase homes, which meant that homebuilders were forced to abandon construction projects. Think of all the products that are used in building and furnishing a home; all of the industries that produced these products generally experienced declining sales. Because houses became primary sources of wealth or perceptions of wealth, falling real estate prices made homeowners feel less economically secure. In a vicious circle, the economic recession, fueled by declining real estate markets, further eroded demand for real estate. But mortgages must be repaid, or the consequences can be severe. Despite decreasing home values, homeowners must continue to pay real estate taxes and spend money on maintenance. Many homes were bought at prices much higher than their actual worth just two or three years later. Rising levels of unemployment also pushed homeowners with strong credit into foreclosure. One in forty-five U.S. households, or 3 million, received a foreclosure filing, and banks repossessed 1 million homes in 2010. 24

The mortgage crisis inevitably spread to financial institutions, causing reputable Wall Street firms such as Lehman Brothers to collapse overnight. Because of Lehman’s pivotal role in finance, its demise in September 2008 is generally perceived as the most tangible evidence of the financial crisis on Wall Street. Iceland, which had a very successful banking system, saw its economy and currency collapse along with the banking system. Ireland, widely regarded as the Celtic Tiger for its rapid economic growth, experienced a deep recession. American consumers, the backbone of the United States and, to some extent, the global economy, had exhausted their resources and had a savings rate that was close to zero.

7.2.2: Decline in Manufacturing and Trade

Manufacturing, already in decline, fell dramatically. This especially was the case in the automotive industry, with General Motors and Chrysler declaring bankruptcy after closing many factories and dealerships, despite unprecedented financial support from the U.S. government. Industrial production was down by 12 percent in Europe, 11 percent in the United States, and 43 percent in Taiwan. Tightening credit and consumer fear ultimately created a downward spiral that significantly diminished global trade. Germany saw its exports drop by 20 percent and China’s exports fell by more than 25 percent. Both economies rebounded, with China surpassing Japan to become the world’s second-largest economy and Germany experiencing the highest economic growth rate in Europe.

7.2.3: High Youth Unemployment

Unprecedented high youth unemployment is one of the most significant global challenges, with far-reaching implications. An estimated 290 million young people are neither working nor studying. Many recent college graduates globally are unemployed or underemployed. In 2013, less than half of China’s college graduates found jobs. Japan’s financial crisis in the early 1990s caused high levels of unemployment among the young and has created a permanent class of unemployed youths, known as  hikikomori , who live with their parents and have essentially withdrawn from society. In Europe and America, many unemployed and underemployed youths are living with their parents or have become homeless. This problem is most severe in South Asia, the Middle East, and Africa, where roughly half of the world’s young people live.

The implications of high youth unemployment are profound. It undermines the confidence of a large part of society in future progress and upward mobility, thereby creating a sense of alienation and hopelessness. It weakens the foundations of the  intergenerational contract , under which children are expected to take care of aging parents, that is prevalent in developing countries. As  Chapter 9  shows, many poor people pass on poverty to future generations, thereby expanding and reinforcing inequality. Youth unemployment contributes to popular uprisings, instability, and violence. Joblessness fuels global protests. Violent crimes have risen significantly in countries with high unemployment such as Egypt, Spain, South Africa, Italy, and Portugal. Youth unemployment rates are as high as 59 percent in Greece and 56 percent in Spain.

The global financial crisis and its aftermath played a pivotal role in creating high youth unemployment. Economic recessions usually drive up youth unemployment because young people lack job security compared to older workers. Many lack skills required for available jobs. For example, China quadrupled college enrollment in the past decade. But China’s economy is based largely on manufacturing, which produces many blue-collar jobs. As in many developing societies, most college graduates are not trained for or interested in these jobs. Whereas only 4 percent of Chinese with just basic education are unemployed, an estimated 16 percent of college-educated Chinese between the ages of 21 and 25 are unemployed. 25

The financial crisis and recession brought into sharper focus other underlying causes of high youth unemployment. These include (1) inflexible labor regulations that make it difficult for young people to enter the job market, (2) high minimum wages, (3) high taxes on hiring, and (4) the lack of apprenticeship programs that combine high school education with on-the-job training. These problems need to be addressed to reduce high unemployment. Governments can play a more active role in finding jobs for young people. Many young people are solving the problem by migrating to countries such as Germany and Australia that offer more economic opportunities.

7.2.4: Global Power Shift

Another major impact of the global financial crisis is a global power shift. Although most countries were negatively affected by the financial crisis and global recession, some emerged stronger than others. Brazil, Russia, India, China, and South Africa, also known as the  BRICS countries , enhanced their power vis-à-vis the United States, Western Europe, and Japan. Within the European Union, Germany emerged with the strongest financial and economic system and greater political and economic power. In sharp contrast to the policies adopted by the U.S. Federal Reserve under Chairman Alan Greenspan, the Reserve Bank of India, led by  Yaga Venugobal Reddy , rejected many financial innovations and limited the participation of foreign investors in India’s financial system. Instead of believing that markets are self-regulating, as many Americans do, the Indian government favored regulations and was quick to recognize financial bubbles. Reddy restricted bank lending to real estate developers, increased the amount of money banks had to set aside as reserves, and blocked the use of some derivatives. This conservative approach enabled India to largely avoid the global financial crisis. 26  Given America’s role in pressuring the world to adopt a financial system that failed, BRICS countries perceive the financial crisis as a serious economic and political setback for the United States and free-market capitalism. All of these countries, sensing America’s vulnerabilities, are becoming more politically and financially assertive. From their perspective, America is declining. It has escalating budget deficits, it is extremely dependent on foreign creditors such as China, and the dollar’s status as the main global reserve currency has eroded. As we saw in  Chapter 2 , America’s economic power following World War II enabled it to shape global financial institutions such as the International Monetary Fund (IMF) and the World Bank. However, the BRICS countries are now challenging America’s leadership. Economic power has shifted from the G-7 to the G-20, the group composed of countries with the largest economies, many of them in the developing world. However, growth in emerging economies has slowed sharply while the old economies of the United States, Europe, and Japan have grown. Power is clearly shifting back. In 2014, the BRICS created the Development Bank, funded with $100 billion, as an alternative to the World Bank and the IMF. The bank, which will provide loans to developing countries, will be headquartered in China (the major donor) and India for the first five years, followed by Russia and Brazil. Other countries can become members.

7.3: Global Responses to the Financial Crisis

1. 7.3 Evaluate the concerns that made different countries respond in different ways to the financial crisis

7.3.1: America’s Response

Responses to the global financial crisis varied from country to country, with the strongest actions occurring in the United States. Being largely responsible for the crisis, the United States was not only the most severely affected but also the most shell-shocked and anxious to find solutions. In a sharp reversal of its strong commitment to economic and financial liberalization and free-market capitalism, the United States has led efforts to nationalize its financial and some aspects of its manufacturing sectors to an unprecedented degree. There was general consensus among Republicans and Democrats that a massive financial and economic  stimulus package , engineered primarily by Secretary of the Treasury  Henry Paulson , was essential not just to rescue America’s financial institutions but also to reassure Americans that their savings and investments were secure. The $475 billion  Troubled Asset Relief Program (TARP)  was passed by Congress to allow the U.S. Treasury to help stabilize the U.S. economy through purchasing or insuring troubled assets in five program areas: banking, credit markets, the auto industry, the American International Group (AIG), and housing. Because the financial crisis was reminiscent of the Great Depression, with its high levels of unemployment and massive withdrawals from banks, the U.S. government responded to avoid repeating the mistakes of the 1930s. Despite various protections implemented to ensure the safety of deposits, such as the FDIC, Americans withdrew $150 billion from money market funds over a two-day period in September 2008, compared with average weekly outflows of roughly $5 billion. The huge amount of money poured into credit markets and banks was designed to restore confidence in financial institutions and to expand credit. Concerned about high unemployment rates and stagnant economic growth, the U.S. Federal Reserve enacted a type of monetary stimulus known as  quantitative easing  (QE). It bought $600 billion in long-term Treasury bonds to push down long-term interest rates. 27  That depreciated the value of the dollar, thereby making American exports less expensive and raising the cost of imports. That, in turn, fueled debates about currency wars. America also responded by electing Republicans in 2010 to replace Democrats who controlled the House of Representatives. A greater emphasis was placed on reducing budget deficits at both the national and state levels. Many public service employees lost their jobs, and public sector unions were severely weakened.

7.3.2: European Responses

Although other countries also implemented stimulus packages, their concerns differed to a significant degree from those of the United States. Germany, for example, resisted American pressure to adopt a more comprehensive, coordinated global stimulus package, partly because many Germans believe that the crisis was primarily an outgrowth of American financial policies and would have to be solved domestically. Germans worry about the possibility of hyperinflation, which the country experienced in the 1920s. Germans are also more frugal than Americans and are reluctant to impose huge deficits on future generations, especially in light of Germany’s shrinking population. Europeans in general took a less frantic approach to the financial crisis because in normal times, their governments had created numerous  safety nets . European governments provide national health insurance and generous pensions, and they have implemented programs to reduce unemployment and lost wages. Because they save a greater percentage of their income, they have avoided losing their homes on such a massive scale as is the case in the United States. However, faced with mounting debts and a worsening financial crisis, many governments implemented austerity programs that cut government budget deficits and raised the minimum retirement age. These changes caused protests in France, Greece, Portugal, Britain, and elsewhere. Leaders of the “euro zone” countries, in which

THE BRICS COUNTRIES, BRAZIL, RUSSIA, INDIA, CHINA, AND SOUTH AFRICA, BENEFITED FROM THE GLOBAL POWER SHIFT CAUSED BY THE FINANCIAL CRISIS. From left, Russian president Vladimir Putin, Indian prime minister Narendra Modi, Brazilian president Delma Rousseff, Chinese president Xi Jinping, and South African president Jacob Zuma joined hands during the 2014 BRICS summit in Brazil.

the single European currency is used, struggled to create an overall policy to deal with the region’s growing debt crisis. Students in Britain protested the government’s decision to increase college tuition and fees. Similar to the United States, the government that was in power in Britain during the financial crisis (Labor), lost its majority to a coalition of Conservatives and Liberal Democrats.

7.3.3: China’s Response

China’s response involved taking measures to strengthen its power vis-à-vis the United States. Unlike the United States, China regulates its financial institutions, has more than $2 trillion in reserves, and continues to have economic growth rates in excess of 7 percent, and the Chinese save more than 40 percent of their income. Despite rising unemployment and declining exports, China emerged from the financial crisis in a strong position and is taking advantage of new opportunities created by the crisis. China is using its $600 billion economic stimulus package to improve its infrastructure, to help its companies become more competitive domestically and globally, and to enhance research and development. It is also gaining greater access to resources and augmenting its relations in Latin America, Africa, the Middle East, and elsewhere, even as the United States is preoccupied with its financial and economic crises as well as with fighting wars in Iraq and Afghanistan. China is also acquiring European and American companies in the automotive, textile, food, energy, machinery, electronics, and environmental protection sectors. One of the most visible acquisitions is the Hummer from General Motors.

7.3.4: Financial Regulations

In light of the general consensus among experts that deregulation and the lax enforcement of regulations in the financial sector contributed significantly to the global financial crisis, an immediate response to the crash was to try to strengthen and update regulations. The chairman of the U.S. Federal Reserve,  Ben S. Bernanke , was particularly aware of the need for new regulations. As a professor at Princeton University, Bernanke focused his research on the Great Depression. The American government was now determined to avoid mistakes made during that financial and economic crisis. Efforts to enact international banking regulations began with the creation of the  Bank for International Settlements , based in Basel, Switzerland. In 1988, the banking community signed the Basel Capital Accord, which attempted to harmonize banking standards, especially those requiring banks to set aside capital to cover the level of risk they faced. However, due to the dominant influence of bankers, the Bank for International Settlements was not very focused on regulations. 28  Since 1999, there has been a greater effort to develop a stronger regulatory framework, known as Basel 2. The accord gave credit-rating agencies an explicit role in determining how much capital is enough to cover certain risks. An agreement known as Basel 3 created new international rules for banks. They raised the amount capital lenders are required to have as a cushion against unexpected financial losses to 7 percent of their capital. 29  But the failures of financial institutions in the United States, Europe, and elsewhere demonstrate that individual countries’ unwillingness or inability to supervise their financial sectors was at the heart of the problem. Consequently, domestic regulatory reforms are likely to be more effective than global regulations. Financial innovations such as derivatives and executive compensation are the primary targets for greater supervision. However, the complex nature of the global financial system and strong reservations in the United States about the government’s role in the economy will most likely diminish the effectiveness of regulations.

7.3.5: Austerity Policies

Excessive borrowing and spending by governments in Western Europe and the United States led to the implementation of austerity policies in the wake of the global financial crisis and economic recession.  Austerity  is the raising of taxes combined with severe and immediate reductions in government expenditures to bring them more in balance with income. 30  It also involves reducing wages and restructuring costly health and retirement programs to achieve savings. In the case of Greece, for example, foreign lenders, especially Germany, demanded severe cuts for Greece to obtain financing to avoid a potentially damaging default. Faced with huge budget deficits and the inability of congressional Democrats and Republicans to collaborate to reduce the national debt, the United States adopted austerity policies in the form of across-the-board spending cuts known as  sequestration .

The poor and the middle class are the most vulnerable to the negative effects of austerity because they are more dependent on government programs and have few resources in reserve to maintain their standard of living. This problem is compounded as major trading partners cut spending simultaneously. Their economies stagnate or contract and, as discussed earlier in this chapter, unemployment rises significantly, especially among young people. In many ways austerity widened the gap between rich and poor. Poverty has grown in America as the Federal Reserve and several state governments have cut unemployment benefits, nutrition subsidies for pregnant women and infants, and public housing budgets. Since health insurance is linked to employment, the more than five million Americans who lost their jobs also faced difficulties obtaining preventive medical care and ended up in hospital emergency departments with life-threatening illnesses. Suicide rates, depression, and drug and alcohol use increased. National health insurance reform that went into effect in the fall of 2013 began to address the problem of uninsured Americans.

Greece has suffered most from austerity policies. Under the terms of a loan agreement with the IMF, the European Commission, and the European Central Bank, Greece laid off roughly thirty-five thousand doctors, nurses, and other health care workers. It also reduced health care benefits for the unemployed to a maximum of one year. The result has been a health care catastrophe. People delay seeking medical treatment for serious diseases such as cancer until it is too late. Infant mortality rose by 40 percent, children are malnourished, and malaria is now in Greece for the first time since 1970 because funding for mosquito-spraying programs was eliminated. 31

Case Study Ireland: The Decline of the Celtic Tiger

Ireland, the second-richest country in Europe before the global financial and economic crisis, now has one of Europe’s weakest economies. What makes the Irish case different and of special interest is that after such a long history of hardship and poverty, Ireland was radically transformed into a highly successful country, becoming the Celtic Tiger in the 1990s, only to see prosperity decline precipitously by 2007. Massive public debt, due largely to the banking crisis, forced Ireland to turn to the European Union and the IMF for financial assistance. Unemployment rose to 14 percent, and consumer spending and incomes fell. Abandoned housing developments proliferated, homelessness increased, and younger Irish emigrated to the United States, Canada, Australia, and elsewhere to find employment.

Ireland endured severe economic problems in the 1980s. Emigration, an integral part of the Irish experience for more than 150 years, rose sharply, draining the country of many talented individuals. High tax rates discouraged foreign investment, and high inflation and high interest rates made it difficult for the economy to recover. Ireland’s entry into the European Union and its adoption of the euro marked a major step toward Ireland’s integration in the global economy. Ireland gained access to low interest rates, and the Anglo Irish Bank and other financial institutions borrowed heavily in the euro interbank market to finance property loans. Ireland’s rapid economic growth was aided by policies implemented by the government led by Charles Haughey. Those included cuts in public spending to reduce the budget deficit, a three-year freeze on wages, and lowering inflation and interest rates. Ireland attracted many companies, especially high-tech industries like Intel, that wanted to gain entry in the European Union before the removal of trade barriers among member countries in 1992. Ireland in many ways resembled South Korea, Taiwan, and other Asian Tigers. It offered a relatively low-wage workforce, highly educated individuals, low  tax rates, and concessions to companies that invested. It also had the advantage of being an English-speaking country with a global diaspora. Ireland’s economic prosperity was closely linked to America’s. Many in the Irish diaspora, especially in the United States, returned to Ireland during the boom in the 1990s, bringing with them skills and capital. Ireland also became a magnet for immigrants from Eastern Europe and elsewhere, many of whom worked in the booming construction industry and in the service sector. Between 1993 and 2000, average GDP growth rates were around 10 percent, similar to rates in China and other Asian countries. Ireland became a Celtic Tiger during this period. But a financial bubble was also developing. Wages and prices rose faster than those in Ireland’s trading partners, which diminished Ireland’s competitiveness. Imports became less expensive, and government deficits grew, as was the case in the United States. At the same time, the cost of living escalated. Ireland had become Europe’s second-richest country overnight.

Ireland, like the United States, turned to investing in real estate following the dot-com bust. The general belief among many Irish was that real estate was a safe investment that would continue to appreciate. Low interest rates, the lack of stringent government regulations, and government corruption fueled a construction boom. Small down payments enabled financially vulnerable individuals to purchase homes. Buyers routinely secured loans worth more than 90 percent of the home’s value, which pushed them into negative equity when property values declined. Speculation was common. People wanting to make money quickly invested in second homes and commercial property. The number of people employed in construction reached 272,000 in 2007, accounting for one eighth of the workforce. When employment in areas related to housing is considered, such as real estate agencies, mortgage brokers, and banks, the housing sector employed a fifth of Ireland’s population. Housing problems were the main cause of the decline of the Celtic Tiger. Ireland experienced a precipitous drop in housing prices.

In an effort to solve its economic problems, Ireland borrowed money, primarily to bail out banks. Germany, the leading EU economy and the biggest creditor, opposed lowering interest rates on Ireland’s debt, favoring instead fiscal discipline. But austerity programs and high unemployment rates lessen the likelihood that consumers will be able to reinvigorate the economy. By keeping corporate taxes low, Ireland is attracting foreign investment as the global economy improves. Ireland’s young and talented workforce will continue to be a major asset that will assist in the country’s economic recovery.

Summary

The global financial crisis ushered in the most severe global recession since the Great Depression of the 1930s. Given the central role played by finances in globalization, the crisis has serious implications for virtually all global issues and for globalization itself. Although this chapter argued that financial crises seem to be an integral component of capitalism, human beings are ultimately responsible for creating them. Revolutions in computer and telecommunications technologies fostered the development of complex financial engineering that radically altered the global financial system. An emphasis on government deregulation, the growth of a culture that encouraged quick profits and excessive executive compensation, and the availability of low interest rates played significant roles in creating the financial crisis. But a crisis presents both dangers and opportunities. While the United States has suffered severe setbacks, China has gained, thereby shifting global power. The financial crisis has significantly reduced global trade and caused unprecedented home foreclosures and high levels of unemployment, especially among young people. The global response has centered around regulating some of the financial innovations, paying greater attention to risk management, monitoring executive compensation, and adopting austerity policies. Overall, the financial crisis has diminished support for financial liberalization and strengthened the role of governments around the world in economic affairs.

Discussion Questions

1. Discuss how deregulation of financial markets and low interest rates contributed to creating the financial crisis.

2. Discuss the implications of the stimulus package for the United States. In light of the benefits derived from Europe’s safety net, discuss the pros and cons of America’s adoption of European policies, such as universal health care and job protection.

3. Discuss the role of subprime loans in real estate in the financial crisis and their broader social and economic implications.

4. Discuss the problem of high youth unemployment, its causes, and its implications.

5. Evaluate the global responses to the financial crisis. Give examples.

Chapter 8 Global Trade

GLOBAL COMPANIES IMPROVE LIVES AND PROMOTE EQUALITY. Infoscions, employees of Infosys, India’s largest software company, walked at the Infosys campus in Bangalore. More than 90 percent of Infosys revenues come from overseas clients.

Learning Objectives

1. 8.1Evaluate the different aspects of the globalization of free trade

2. 8.2Recognize how corporations became more global in both their outlook and their operations after the mid-1970s

3. 8.3Report the phenomenon of the race to the bottom to be the cause for the loss of manufacturing jobs in the developed nations

4. 8.4Recall the role played by global companies in promoting equality

5. 8.5Identify the contributing factors to the decline of labor unions

6. 8.6Recount controversies related to global trade

7. 8.7Recount the factors that have helped environmental issues become a concern in global trade

8. 8.8Review the functionalities of different trade blocs

The origins of global trade are as old as human society. Lacking complete self-sufficiency, human beings traded goods and services within their communities and gradually expanded trade with people in distant areas. Trade is an integral component of economic growth and development. Trade plays a pivotal role in the rise and decline of great powers. For example, China’s global trade contributes to its emergence as a challenger to the United States for global power. Asia’s rapid economic growth, high levels of employment, and dramatic poverty reduction occurred as trade expanded with increased economic globalization. Global trade is also a driving force behind the huge rise in global inequality. Most of the recent financial gains from trade are enjoyed by a global elite comprising 1 percent of the world’s population. Global trade clearly shows the political, economic, and cultural aspects of globalization. Global trade is so integral to our daily lives that we are generally oblivious to how it links us to the rest of the world. Some of our most important agricultural crops are not native to North America. In fact, it is difficult to think of a country that has not been affected by the transfer of food crops from some distant area.

The story of sugarcane vividly illustrates this point, as  Figure 8.1  shows. More than eight thousand years ago, inhabitants of New Guinea, located north of Australia, discovered that grass, similar to bamboo, not only was sweet but could be easily cultivated by planting segments of it. This was the beginning of the global sugar trade, a development that would profoundly affect most of the world. Human craving for sweet foods facilitated the spread of sugarcane from New Guinea across Southeast Asia to India, which began producing crystal sugar around 500 bce. Traders soon took sugarcane from India to China and Persia (now Iran). The spread of Islam from Saudi Arabia to Egypt, across North Africa, and into the Mediterranean and Spain was accompanied by the spread of sugar cultivation.

Spanish and Portuguese colonization of the Americas marked a turning point in the cultivation, production, and consumption of sugar. Widely regarded by Europeans as a luxury product, sugarcane was soon cultivated on a massive scale throughout the Caribbean and Latin America. Requiring intensive labor, sugarcane cultivation fueled the transatlantic slave trade and numerous conflicts among European countries for control of the sugar-producing Caribbean islands. For example, France gave its territory in Canada to Britain partly in exchange for the two sugar-growing islands of Martinique and Guadeloupe under the  Treaty of Paris of 1763 , which ended the Seven Years’ War between the two European powers. By the 1830s, sugar cultivation spread to Hawaii, thereby completing its journey around the world and becoming a significant part of our diet. Our lives are increasingly affected by the webs of global interdependence that are integral parts of global trade. What’s more, the ability of countries to control their economic activities is steadily being eroded by economic globalization.

Many scholars have concluded that global trade and other aspects of globalization are transforming the functions of states. They see a shift in power away from countries to global companies and point to taxing power, an essential component of national sovereignty, to illustrate their point. Even more important is the weakening of traditional bonds between citizens and governments. 1

This chapter examines the growth of free trade, concerns about trade deficits and surpluses among countries, and how budget deficits and the relative value of currencies affect global trade. It also discusses how America’s soaring oil and natural gas production is affecting global trade. We will discuss various trade disputes and how those disputes are resolved by emerging global institutions. Finally, we will discuss the impact of trade on the environment and the global spread of diseases and their implications for global trade and trade blocs. The chapter concludes with a case study of global food safety.

8.1: The Globalization of Free Trade

1. 8.1 Evaluate the different aspects of the globalization of free trade

As early as the third century bce, various nomadic groups and Chinese merchants established a trading route known as the  Silk Road . Linking China with the West, the Silk Road served as a commercial and cultural bridge between the two regions. The spread of Islam from Saudi Arabia to North Africa and the Middle East and across Asia as far as Indonesia (the most populous Muslim country) was accompanied by trade. But trade in Europe, Asia, and elsewhere was often restricted by protectionist measures imposed by governments. Many governments adopted the  mercantilist model  of trade. It stressed the role of government in trade and emphasized the importance of balance-of-payment surpluses in trade with other countries. At the extreme is  autarky , which promotes economic national self-sufficiency.

Removing impediments to the free flow of goods and services among countries is the foundation of free trade or trade liberalization. The consensus among advocates of free trade is that it reduces prices, raises the standard of living for more people, makes a wider variety of products available, and contributes to improvements in the quality of goods and services. Adam Smith, David Ricardo, and other economists believed that by removing barriers to the free movement of goods among countries, as well as

Figure 8.1 The Global Spread of Sugar

Sources: Kenneth Kiple and Kriemhild Omelas, eds., The Cambridge World History of Food (Cambridge: Cambridge University Press, 2000); Christian Science Monitor, August 5, 2003, 18.

Figure 8.1 Full Alternative Text

within them, countries would be encouraged to specialize in producing certain goods, thereby contributing to the optimum utilization of resources such as land, labor, capital, and entrepreneurial ability. If countries focused on what they did best and freely traded their goods with each other, all of them would benefit. David Ricardo (1772–1823), a British economist, best articulated this concept, known as  comparative advantage . Ricardo explained, for example, how it was more economically advantageous for Britain to produce cloth and for Portugal to produce wine, as long as they engaged in free trade.

The theory of comparative advantage has been undermined by the current wave of economic globalization. The growth of transnational or multinational corporations (MNCs) complicates global trading. The production of goods and services is strongly influenced by costs, arbitrary specialization, and government and corporate policies. These developments mark a shift from the conventional theory of comparative advantage to what is known as  competitive advantage . 2  Despite global acceptance of the concept of free trade, governments continue to engage in protectionism. For example, the European Union (EU) and the United States each support their own commercial aircraft industries so that those industries can compete more effectively in a market dominated by a few companies. The idea of assisting such industries, which represents a departure from free trade, is known as the  strategic trade theory . 3

Movement toward free trade occurs because of a consensus that free trade is more beneficial to more countries and individuals than its alternatives. This is demonstrated by Britain’s repeal of its Corn Laws and the United States’ retreat from protectionism. In 1815, the British Parliament passed the  Corn Laws  to protect the wealthy producers of grain from foreign competition, thereby ensuring that the landed upper classes would receive high prices for their crops. Simultaneously, Britain promoted exports of its manufactured products to Europe, the United States, and its colonies. However, it became increasingly apparent that Britain could not produce sufficient food to feed its population and that the United States and European countries were adopting their own protectionist policies to safeguard their infant industries from British manufactured products. The Irish potato blight and the accompanying famine highlighted the dangerous and deadly consequences of Britain’s policy of keeping food prices artificially high to protect upper-class interests. Outraged by widespread starvation, Britain’s trade liberals, inspired by Ricardo’s theory of comparative advantage, formed the Anti-Corn Law League to influence Britain to repeal the Corn Laws and to unilaterally adopt free-trade policies, regardless of whether other countries reciprocated. To a large extent, Britain’s global leadership enabled it to induce other countries to adopt free-trade practices by setting the example. Britain’s repeal of the Corn Laws and the Navigation Acts in 1846, which restricted the transport of goods to British ships, brought about the first period of relatively free trade among Western countries.

Trade protectionism did not retreat completely, however. By the end of the nineteenth century, many countries engaged in trade protectionism. The outbreak of World War I radically altered the global economic system and led to increased international economic instability. Widespread international economic problems that came with the onset of the Great Depression in 1929 influenced many countries to pursue autarky and protectionism. The enactment of the  Smoot-Hawley Tariff Act  in the United States in 1930, designed to protect American industries and trade, ultimately influenced other countries to increase their own tariffs. This development worsened global economic conditions. Attempting to diminish the negative economic consequences, the United States moved away from its protectionist policies by enacting the  Reciprocal Trade Agreement Act  of 1934, which authorized the president to negotiate substantial tariff reductions on a reciprocal and bilateral (i.e., between two countries) basis with other countries. 4  The rapid decline in global trade between World War I and World War II strongly influenced the United States and Western Europe to embrace freer trade.

At the Bretton Woods Conference in New Hampshire in 1944, the United States and its allies created (1) the  International Monetary Fund (IMF)  to manage exchange rates and payment imbalances among nations and (2) the  International Bank for Reconstruction and Development (World Bank)  to supplement private capital for international investment, with an emphasis on the reconstruction of Western Europe. American and European concerns about the negative consequences of protectionism and their strong desire to promote free trade led to the establishment of the  General Agreement on Tariffs and Trade (GATT)  in 1947 to serve as a negotiating forum for the reduction of tariffs and other barriers to trade.

There were several premises, or assumptions, of GATT. These stated that:

1. Multilateral negotiations (involving many countries) are preferable to bilateral negotiations (between two nations) on trade issues.

2. Private economic actors are preferable to governments for conducting and managing international trade.

3. Free trade ultimately benefits the global society.

4. Governments distort the operation of the free market and should minimize their involvement.

Between 1947 and 1992, various meetings of GATT (known as rounds) resulted in significant reductions in tariffs and freer trade. However, GATT covered manufactured products but excluded trade in agriculture and  services. The  Uruguay Round  (meetings of GATT held in Uruguay from 1986 to 1992) added services and agriculture to the global trade framework and replaced GATT with the World Trade Organization (WTO) in 1993.

Although the premises of GATT continue to be the foundations of global trade liberalization, the WTO differs significantly from GATT. To a much greater extent than GATT, the WTO directly challenges fundamental aspects of national sovereignty by diminishing both the national barriers to global trade and governments’ economic activities. For example, when China joined the WTO in 2001, it was required to make its domestic market more accessible to foreign competition and to privatize its state-owned industries. On the other hand, China benefited from provisions of the  Most-Favored Nation Clause , which was a key component of GATT. This clause reduces trade discrimination among members. WTO rules apply to activities generally regarded as domestic policies and beyond the reach of international regulations. Compared with GATT, the WTO is much more powerful in terms of governing global commerce and is empowered to settle trade disputes among countries. Agreements establishing the WTO extended GATT rules to cover agriculture, consumer services (restaurants, hotels, travel agencies, and so on), producer services (investment; banking; insurance;  intellectual property rights , or the control people have over their artistic, creative, scientific, industrial, and educational inventions; and data processing), textiles, clothing, telecommunications, labor standards, and the environment. They also call for greater transparency in writing product standards and testing procedures and in soliciting bids on government contracts. 5  WTO regulations also reduced or eliminated many import quotas and subsidies. For example, the Multifiber Agreement, an international arrangement concluded in 1974, used import quotas to regulate the more than $350 billion world trade in garments to benefit many developing countries and to protect domestic industries. Because such arrangements violate WTO rules, the Multifiber Agreement was allowed to expire.

The 142 member countries of the WTO met in Doha, Qatar, in 2001 to further reduce barriers to trade. The  Doha Agreement , which reflected the growing power of developing countries regarding trade issues, relaxed patent protection for brand-name drugs by giving poor countries the right to make inexpensive generic medicines patented by global pharmaceutical corporations. Brazil, India, and many other developing countries, especially those ravaged by AIDS, viewed this concession as an important victory. However, resistance to certain aspects of trade globalization in the developing world led to the collapse of two subsequent WTO meetings. At the heart of the controversy was the extent to which domestic industries should be protected from foreign competition. The global economic recession, which sharply reduced global trade, put these issues on the back burner and focused attention on currency problems and the need for major changes. The Doha negotiations in Bali led to an agreement to facilitate global trade by simplifying customs procedures. 6  However, this global agreement was later vetoed by India, with the support of Cuba, Venezuela, and Bolivia. India wanted the WTO to relax its rules on subsidies and stockpiling food in exchange for India’s support of trade facilitation. Four months after India vetoed the global trade agreement a compromise reached between India and the United States restored the original trade deal.

8.1.1: Exchange Rates, Budget Deficits, and Trade

The  exchange rate  for a currency is how much of one country’s money can be bought with a specified amount of another country’s money. 7  The business sections of major newspapers show that the values of currencies fluctuate constantly as a result of trading in foreign exchange markets, just as the values of stocks fluctuate on stock markets. The strength or weakness of currencies is determined by supply and demand, as is the case with commodities. Supply and demand can often be influenced by deliberate actions of governments and their central banks to buy or sell currencies, thereby affecting the price of currencies.

The relative values of currencies directly affect global trade and domestic economies. A weak dollar (weak relative to other currencies) increases prices for imports in the United States. But a weak dollar also makes American exports less expensive in foreign markets, which stimulates economic productivity in the United States. More jobs are created, and trade deficits with other countries decline. It allows American manufacturers to more effectively compete with less expensive imported manufactured products. But not all countries allow their currencies to fluctuate, which complicates the positive effects of a weak American dollar. China, for example, is likely to continue to have a trade surplus with the United States as long as its currency, which is pegged to the U.S. dollar, remains cheap compared with the dollar. Countries can also buy more dollars to increase the dollar’s value relative to their own currencies, thereby protecting their exports to both the United States and Europe. A weak U.S. dollar can have substantial negative implications for America. Because the United States is so dependent on imported products—such as electronics, clothing, cars, and petroleum—a weaker dollar ultimately leads to higher consumer prices. Furthermore, huge U.S. budget deficits are funded by a net inflow of capital from abroad, meaning that the United States gets more money from other countries than it sends to them. Emerging market economy countries, mainly China, hold two-thirds of global foreign exchange reserves, which are roughly $8.4 trillion. Because they are reluctant to allow their currencies to rise against the dollar, they essentially shadow the dollar in an arrangement that is called  Bretton Woods 2 . A weak dollar increases demands from China, for example, to replace the dollar as the leading global reserve currency. China has concluded agreements to decrease dollar-based global trade and allow the use of other currencies with several countries, including Japan, Brazil, Russia, and Turkey. But China has accumulated so many dollars that it resists allowing the yuan to fall against the dollar. China limits credit growth to prevent domestic inflation. 8

8.1.2: Barriers to Free Trade

Even though most countries embrace trade liberalization (i.e., the movement toward unrestrained free trade), many governments engage in protectionist practices that impede the global free flow of goods and services. Many contemporary opponents to free trade essentially embrace neomercantilism (i.e., a new and more modern version of mercantilism). They argue that protectionism is essential to protect national security. Similarly, many developing countries argue that their need to achieve economic development, which includes economic diversification, justifies implementing protectionist policies. Finally, many antiglobalization activists view free trade as a threat to both the environment and respect for human rights. However, increasing violence against the Roma in Hungary and elsewhere underscores that rising unemployment and economic hardships that resulted from a decline in global trade can intensify human rights violations. 9

The United States has maintained a trade embargo against Cuba to end the Castro regime and promote democracy that has effectively impeded free trade between the two countries. Furthermore, the United States attempted to pressure other countries, such as Canada and members of the European Union, to refrain from engaging in commercial relations with Cuba. These efforts have largely failed. Another barrier to free trade is the formation of natural resource cartels, such as the Organization of Petroleum Exporting Countries (OPEC), which deliberately limit supplies to increase prices or impose sanctions on importers to influence their political decisions or to punish them for particular actions.

8.1.3: Do Trade Deficits Matter?

Huge American trade deficits, especially with China, have linked the loss of manufacturing jobs to trade deficits in the minds of many Americans. The persistent rise in the U.S. trade deficit has arisen as a potent social and political issue. The  trade deficit  is the difference between the value of goods and services that a country buys from overseas and the value of goods and services it sells to other countries. The global economic recession led to significant declines in both exports and imports. Apart from the loss of manufacturing and service jobs in the United States, trade deficits have other significant consequences. Higher levels of unemployment mean less revenue for the government and higher government expenditures on social services and other benefits for the unemployed. Trade deficits are closely related to budget deficits, although many other factors contribute to the large U.S. budget deficit. To pay for its trade and budget deficits, the United States borrows money from foreign investors, such as China and Japan, and global financial institutions. This reliance on foreign capital to pay for debt makes America vulnerable to pressure from abroad. 10  Having a trade deficit in the United States means that other countries have a  trade surplus ; that is, the value of the goods and services they export is greater than the value of goods and services they import. From a neomercantilist viewpoint, trade deficits and surpluses directly affect a country’s economic and military power. Countries with a trade surplus produce more engineers and scientists, attract more talent, and accumulate more financial resources to continue having high levels of productivity and innovation. This means that they acquire greater manufacturing capacity, higher levels of employment, and improvements in the development of intellectual property.

Contrary to the view that trade surpluses are positive and trade deficits are negative, some scholars, such as Joseph Quinlan and Marc Chandler, argue that this thinking is outdated and does not reflect contemporary global trade realities. 11  A fixation on imports and exports ignores how global companies operate. Many American companies pioneered the practice of establishing foreign affiliates and subsidiaries through which they sell goods and services instead of exporting them from the United States. Most global companies follow the rule of “make where you sell” because of growing competition for global markets. While most Americans think of trade in national terms, American companies focus less on national ties and more on global market considerations.

8.2: Global Companies and Global Factories

1. 8.2 Recognize how corporations became more global in both their outlook and their operations after the mid-1970s

MNCs are closely associated with what some scholars call Fordism (i.e., the manufacturing system that stressed mass production of standardized products, and the centralization and vertical integration of production processes). Initially, these companies’ factories were located in a major industrial city in Europe or the United States. Between World War II and the early 1970s, many of these companies expanded their operations into industrialized countries but remained characterized by large-scale fixed investments and large structures. They were relatively immobile and vulnerable to sudden interruptions of production due to material shortages or strikes by workers. Post-Fordism refers to the period after the mid-1970s when companies became more decentralized in virtually all aspects of production. Corporations became more transnational, or more global, in both their outlook and their operations.

Revolutions in communications and computer technologies and transportation radically altered the way companies organize and conduct business. Communication within corporations occurs almost effortlessly, regardless of where various operations of the corporation are located. Financial globalization also contributes to the growth of global companies because it enables them to gain access to investment capital from around the world. Increasingly, most of America’s corporations derive most of their revenues from abroad. Despite the recession in the United States, companies such as Walmart, Caterpillar, Coca-Cola, and McDonald’s made money because of their foreign operations.

Global companies establish global factories that produce a wide range of goods. Most likely the labels on our clothes indicate that they were made in Mexico, China, Malaysia, Bangladesh, Singapore, Indonesia, or Fiji. Gillette, an American company in Massachusetts, has razor handles made in China and cartridges manufactured in Germany. Most consumers are not overly concerned about where these products are made. The fact that transportation by water is so much less expensive than by land encourages global trade and gives certain countries a definite advantage. However, the earthquake and tsunami that devastated Japan directly affected global trade. Many companies were unable to ship products to or from Japan because of the destruction. The practice of just-in-time production (which avoids maintaining an inventory and gets materials only when they are needed) was severely undermined.

8.2.1: Insourcing

After several decades of shifting manufacturing abroad, known as offshoring or outsourcing, companies in the United States and Europe are retreating from offshoring and concentrating more on  insourcing , or making products in their home countries. Several factors are contributing to this development: (1) rising labor costs in China and elsewhere, (2) high levels of unemployment in America and Europe, (3) rising costs of shipping, (4) soaring oil production and falling natural gas and gasoline prices in the United States, (5) increased labor productivity in America and Europe, (6) concerns about the loss of intellectual property, and (7) innovative technologies such as 3-D printing.

Wages in China have risen dramatically and are expected to continue to increase. While other countries have low wages, China had the advantage of scale, efficiency, and excellent supply chains. While wages in China have risen by roughly 18 percent a year, manufacturing pay in America and Europe has declined, giving these countries a competitive advantage. Furthermore, high levels of unemployment in Europe and America in the wake of the financial crisis have forced workers to accept lower wages and have generated public hostility toward offshoring jobs. Many companies are reluctant to move jobs abroad under these circumstances. As oil prices have risen by as much as three times what they were a decade ago, shipping products across the Pacific has become more expensive. Many companies now focus on making products closer to their customers and reducing time spent transporting them over long distances. With technological breakthroughs in natural gas production, costs have declined significantly. Natural gas is about four or five times as expensive in Asia than it is in the United States. Consequently, manufacturing products in energy-intensive factories is much cheaper in America than in China. More Chinese companies are manufacturing in the United States in response to these developments and higher American worker productivity.

Reinforcing the trend toward insourcing is the growing use of robotics and computing technologies that increase labor productivity, thereby reducing the need for labor and diminishing labor costs in manufacturing products. Many companies are concerned about the loss of intellectual property in places such as China. China has been able to obtain new technologies by pressuring Western countries interested in doing business there to share their technology and innovations with Chinese companies. Many U.S. and European companies also see advantages to manufacturing products closer to sources of research and development and maintaining their edge in innovation. 12  Finally, new technologies such as 3-D printing, which speed up development from an idea to a finished product and can customize products for individual consumers, are influencing companies to locate in the United States and Europe.

8.2.2: Safety at Global Factories

When the Rana Plaza garment factory collapsed, killing 1,129 workers, it was a tragic reminder of the lack of safety in global factories that produce clothing for the world’s leading retailers at the lowest prices. Bangladesh, which has sixteen hundred garment factories, is second only to China as a garment-manufacturing center. The industry makes up a fifth of the country’s economy and a fourth of

WORKERS RESCUED A WOMAN WHO HAD BEEN TRAPPED 78 HOURS IN THE RUBBLE OF THE RANA PLAZA GARMENT FACTORY. More than a thousand died when the eight-story building in Bangladesh collapsed, raising the issue of the lack of safety in global factories.

its annual exports, which total $20 billion. More than four million people are employed in garment factories. Many government officials benefit directly from the industry. It is almost routine to hear of fines and buildings disintegrating in Bangladesh because of lax building code enforcement. Inspections are superficial, bribes are common, and factory managers are usually notified before inspectors arrive so that they can unlock fire exits, keep out child laborers, and do what is necessary to pass inspections. Crammed in congested neighborhoods, many factories are virtually inaccessible to fire trucks.

Global reaction was immediate following the Rana Plaza collapse. A large coalition of religious groups and investors, organized by the  Interfaith Center on Corporate Responsibility , pressured major American retailers such as Walmart, Target, Sears, Gap, Calvin Klein, and Tommy Hilfiger to participate in efforts to improve factory safety. University chapters of  United Students Against Sweatshops  organized a series of demonstrations against Gap in Boston, Los Angeles, New York, and Washington. European companies adopted a safety agreement requiring companies to have rigorous independent inspections of factories and to help pay for safety improvements. The agreement also strengthens the role of workers and unions in insuring factory safety. It is legally binding. Most American companies did not sign the agreement. Although many nongovernmental organizations (NGOs) pressured global companies to improve factory safety, consumers did not play a major role. Many consumers expect low clothing prices and do not have an interest in raising them. Without pressure from consumers, safety problems are likely to remain. Bangladeshi lawmakers passed legislation to strengthen workers’ protection and to raise wages to $68 a month. Many companies, fearing the impact of negative publicity, looked for alternatives to Bangladesh such as Vietnam, Cambodia, and Indonesia.

8.3: Global Trade and Low Wages

1. 8.3 Report the phenomenon of the race to the bottom to be the cause for the loss of manufacturing jobs in the developed nations

The relentless search for lower production costs in politically stable countries has led to what is known as a race to the bottom. The constant loss of manufacturing jobs in the United States, Japan, and Europe as companies move production to countries with low wages and competent workers has motivated coalitions of labor union members, consumers, and environmentalists to try to slow this race to the bottom. However, from the perspective of many developing countries, these efforts are thinly disguised protectionist measures aimed at safeguarding jobs in the developed countries. This is a common theme in the outsourcing debate.

China has an almost inexhaustible supply of skilled workers who are willing to work for low wages. In many ways, China is a factory to the world. Japanese apparel companies, such as Fast Retailing, have built factories in China to avoid paying high wages in Japan. Japanese electronic companies—such as Toshiba Corporation, Sony, Matsushita Electric Industrial Company, and Canon—have operations in China. Like many American workers, Japanese workers accuse these companies of exporting jobs to China. Countries such as Vietnam and Indonesia are competing with China in the area of manufacturing. Furthermore, growth in China has led to demands by workers for higher wages and better working conditions.

8.3.1: Sweatshops and Child Labor

Sweatshops are widely perceived as integral components of the global economy. They provide much needed jobs in countries that suffer from extreme poverty. But they also underscore the need for global companies in a very competitive market to produce low-cost products for insatiable consumers. Garment workers in Bangladesh, for example, are paid the lowest wages in the world. This has made Bangladesh the second-largest producer of clothing for leading global companies after China. Factory owners and government officials collaborate to depress wages. In fact, many government officials own factories or have financial interests in the industry. The term  sweatshop  is used to portray dangerous working conditions; long hours and low pay; difficult and hazardous jobs; frequent and serious accidents; harsh supervision; few employee benefits; and the generally toxic, polluted, and unsanitary environment found in most factories.

Opposition to sweatshops from labor unions, environmentalists, human rights advocates, and other influenced many companies, including Nike and Walmart, to enact measures to improve conditions in factories that produce goods for them, including (1) greater government regulation of factories, (2) safety and health regulations, (3) insurance, (4) laws forbidding using child labor, and (5) monitoring of factories by independent external organizations.

Child labor  is a leading global problem. Approximately 218 million children aged five to fourteen work in developing countries. Economic development and globalization serve as catalysts for the growth of child labor, the cheapest labor of all. Children work in industries such as metal manufacturing, fireworks, brick kilns, and carpet weaving. Pakistan used to rely primarily on child labor in the soccer ball industry. Forced by negative global publicity and the unwillingness of importers and consumers in the United States, Western Europe, and elsewhere to purchase soccer balls made by children working in sweatshop conditions, Pakistan largely abandoned using child labor. But the use of child labor continues, largely because of dire poverty. Without income earned by children, many families would not survive. India, Bangladesh, Pakistan, Thailand, Indonesia, and the Philippines have the largest number of child laborers. The  UN Convention on the Rights of the Child  (1989) has been ratified by all countries except the United States and Somalia. It protects children under the age of seventeen from economic exploitation and from doing work that is hazardous, interferes with the child’s education, and may be harmful to the child’s health and development.

Global companies such as Apple, Nokia, and Samsung rely on minerals that are mined by child labor in the Democratic Republic of the Congo to manufacture mobile phones and other electronic devices. Boys as young as twelve spend days underground working in horrific conditions. They are essentially enslaved. Child labor is intertwined with the ongoing regional war and with widespread violence, especially against girls and women, and general lawlessness and corruption.

8.4: Global Companies Promote Equality

1. 8.4 Recall the role played by global companies in promoting equality

As we saw in  Chapter 2 , global companies build global teams that are composed of some of the most talented individuals in the world. This means that American students often must compete with Indian or German students for employment. Because companies compete for market, they must also cultivate consumers for their products. Furthermore, they are vulnerable to pressure from shareholders, governments, and NGOs to behave in certain ways. Consequently, they develop business and management practices that are virtually uniform globally. The realities faced by global companies influence them to promote equality. Also, many leaders of global companies come from societies where equality is widely practiced.

In India, where the caste system remains embedded in the culture in many parts of the country and is an impediment to equality, global companies directly challenge it by providing special training and employment opportunities for the dalits, also known as untouchables. At its California-style campus in Bangalore, the corporation Infosys hires dalits, many of whom take on a corporate identity as Infoscions. This directly challenges their identity that is derived from the caste system. In South Korea, where talented and highly educated women rarely become senior managers, foreign global companies recruit and promote Korean women. Goldman Sachs has more women than men in its Seoul office. As the rapid economic growth of emerging market countries encourages global companies to expand business operations there, opportunities for the poor increase, and women in particular benefit from the companies’ commitment to equality.

8.5: Labor Unions and Global Trade

1. 8.5 Identify the contributing factors to the decline of labor unions

In this section, we will discuss some of the reasons for the relative decline of the power of unions, as well as strategies unions use to enhance their bargaining power as trade becomes increasingly globalized. Several factors have contributed to labor unions’ decline:

1. Public perceptions of unions: Prior to the 1980s, unions throughout the industrialized world exerted great pressure on industries to obtain better wages and benefits. Often, they became forces of conservatism, resisting much-needed changes. Consequently, they were perceived by many citizens as being responsible for the economic problems that resulted from this rigidity.

2. Political change: During the 1980s, many European countries, the United States, and Canada elected leaders who were strongly committed to free trade, including the operation of free-labor markets. Combined with a wave of privatization and the declining role of government in the economy, the embrace of economic neoliberalism undermined unions’ power.

3. The shift from manufacturing to a knowledge-based economy: Most unions are in the manufacturing and public sectors. The rise of information technology and a knowledge-based economy radically shifted power away from manufacturing to industries that rely on highly educated employees.

4. The globalization of individualism: A growing sense of individual autonomy and the weakening of loyalties to organizations and institutions worldwide helped undermine the power of unions, which depend on group solidarity.

5. Global competition for employment: Workers in developing countries realize that their low wages give them an advantage in their competition with workers in rich countries.

6. The global financial crisis and economic recession: The crisis, which led to high unemployment in Europe and the United States, weakened unions.

7. New technologies: Computers and robotics have increased productivity and profits while enabling companies to shed jobs.

8. The loss of dominance of U.S. manufacturing companies: The re-establishment and growth of foreign competition after World War II from European and Asian manufacturers weakened American dominance.

Facing these formidable obstacles, labor unions have attempted to demonstrate that globalization is detrimental to too many people and beneficial to too few. Labor leaders view globalization as a leading cause of both domestic and global inequality and environmental degradation. Consequently, they have formed alliances with environmentalists, consumer advocates, students, and human rights groups to counteract global trade’s negative impact on them. Another strategy widely used by labor unions is to organize workers in developing countries to establish acceptable labor conditions. However, competition among countries for employment diminishes the success of this strategy. Linking labor standards to global trade agreements would, in the view of poor countries, effectively undermine their competitive advantage.

8.6: Global Trade Disputes

1. 8.6 Recount controversies related to global trade

Controversy is an inevitable part of life. Global trade is no exception. Each country tries to influence other countries to abide by free-trade rules while simultaneously trying to find ways to avoid following free-trade rules that undermine their own economic interests. Although Europeans and Americans steadfastly provide subsidies for their farmers, they routinely accuse each other of engaging in unfair trade because of those subsidies. Trade disputes are often complicated by divergent interests within countries. Inexpensive imports from China benefit many Americans who are raising families on tight budgets but deprive others of their jobs and thus their ability to provide for themselves and their families. Trade disputes are intertwined with domestic politics and with cultural preferences in virtually all countries. For example, disputes between Europeans and Americans about genetically modified foods are political, economic, and cultural. European political leaders are constrained by the reluctance of European consumers to eat such foods, whereas American political leaders are pressured to secure export markets by industries producing genetically modified food and are supported by most Americans, who are more receptive to scientific advances and less concerned about consuming genetically modified food.

8.6.1: Tariffs

It is generally believed that many  tariffs  stifle trade. For example, Ghana sells cocoa beans to Europe without having to pay customs tariffs. However, when Ghana processes cocoa beans to make chocolate and other products, which are far more profitable and beneficial to that country’s economy than exporting beans is, its exports of processed cocoa are subject to a 50 percent tariff. Despite their emphasis on both global free trade and economic development, the United States, Europe, and Japan impose very high tariffs on basic exports—such as sugar, textiles, and fruits and vegetables—for which developing countries enjoy a comparative advantage because of their low labor costs. Brazil, for example, raised concerns about U.S. tariffs on Brazilian ethanol. Brazil, the world’s largest exporter of frozen orange juice, mainly to the United States and Western Europe, accused the United States of imposing unfair tariffs. The WTO ruled that the United States was illegally taxing Brazil’s orange juice. The WTO also decided that China had unfairly imposed tariffs on imports of U.S. chicken parts. U.S. exports dropped by 80 percent.

8.6.2: Quotas

A transatlantic banana war raged between Europe and the United States for eight years following Europe’s decision to erect barriers against imports of bananas grown by Chiquita and Dole (American companies) in Latin America in an effort to protect banana imports from its former colonies in the Caribbean and Africa. Beginning in 1993, when Europe formed a single agricultural market, banana  quotas  were imposed. The United States challenged Europe’s preferential system in the WTO. The WTO concluded that the European banana quota violated trade rules and authorized the United States to impose retaliatory sanctions on $191 million worth of EU exports. The United States targeted high-end European imports such as Louis Vuitton plastic handbags, Palais Royale bed linens, and pecorino cheese. It imposed 100 percent tariffs on them to make them so costly that consumers would not purchase them. However, Americans continued to purchase Louis Vuitton handbags, which normally sold for around $400 before the tariffs, at twice their usual price after the tariffs went into effect. Exhausted by this relatively insignificant trade dispute that was negatively affecting far more important aspects of their relationship, Europeans and Americans decided to compromise. The Europeans agreed to a transition period of modified quotas and tariffs that lasted until 2006. The United States, which had originally demanded an immediate end to all quotas, agreed to remove its punitive tariffs. The banana war finally ended in 2009 when Europe removed banana quotas. Concerned about imports of lower-priced tomatoes from Mexico, Florida growers pressured the U.S. government to get Mexico to raise the minimum sales price to allow U.S. tomato growers to be competitive. Half of the tomatoes consumed in the United States came from Mexico. A tomato war was averted by an agreement between the two countries.

Now that China has emerged as the country with which America has the largest trade deficit, Chinese exports are becoming a source of dispute between the two countries. The United States imposed import quotas on selected Chinese textiles and clothing, largely in response to pressure from elected officials, businesses, and workers in North Carolina. While China claimed that such quotas violate free trade, the United States invoked a safeguard clause, which allows countries facing a sharp increase in textile or apparel imports, combined with job losses, to limit such imports. However, industrialized countries agreed to eliminate all quotas and tariffs on textile and apparel imports from developing countries by 2005.

8.6.3: Subsidies

China heavily subsidizes its industries, thereby gaining industrial dominance. China has many disputes with the West over subsidies for auto parts, solar panels, steel, paper, and telecommunications network equipment. The WTO ruled in 2011 that the U.S. federal and state governments had provided illegal  subsidies  to Boeing so that it would gain an advantage over its European rival, Airbus. But the WTO also found that the European Union had illegally subsidized Airbus. Although government subsidies to various industries create trade disputes among nations, nothing evokes more controversy and conflict than agricultural subsidies in Europe, the United Sates, Japan, and other rich countries. Even as these rich countries prohibit governments in the developing world from subsidizing farming—an occupation that provides a livelihood for roughly two-thirds of the population in poor countries—they continue to subsidize their own farmers and to give them an unfair advantage in the global market. Agricultural subsidies in developed countries originated largely to assist farmers and to provide more food security. In Europe and the United States, these subsidies contribute to overproduction and waste. In both Europe and the United Sates, huge amounts of grain, butter, cheese, wine, and other agricultural products are in storage. This overproduction problem is solved partly by encouraging Americans and Europeans to consume more food and by dumping agricultural products in developing countries’ markets, selling them for below-cost prices. The European Union provides subsidies to agriculture under the  common agricultural policy (CAP) . The original objectives of CAP included (1) improving agricultural productivity, (2) improving living standards for those engaged in agriculture, (3) stabilizing markets, (4) guaranteeing regular food supplies, and (5) providing food at reasonable prices to consumers. However, agriculture has changed significantly since CAP was established in 1968. Only about 5 percent of Europeans are engaged in agriculture, and agricultural science has contributed to dramatic increases in productivity.

Influenced by the devastating impact of the Great Depression on farmers, the United States enacted agricultural legislation in 1933 as part of the New Deal to stabilize farm prices and to save family farming. At that time, roughly 21 percent of the American population engaged in farming, compared with less than 2 percent today. Improved seeds, better farm machinery, and general advances in agricultural science and technology have raised the productivity of an acre planted in corn from 34 bushels then to more than 137 bushels now. Despite revolutionary developments in farming and the success of American farmers, the U.S. government continues to subsidize agriculture. The larger the farm, the greater the amount in subsidies it will receive. This system influences farmers to expand their acreage and to overproduce. As is the case in Europe, American agricultural subsidies are maintained through what is known as the  iron triangle ; that is, the political relationship among members of congressional committees who are affected by farm issues, interest groups, and government agencies whose existence is closely linked to farming interests.

8.6.4: Genetically Modified Food

As global trade facilitates transferring food from one country to another and as consumers become more aware of health risks associated with food, trade disputes based on real and perceived health problems are proliferating. Unlike the other trade disputes we have discussed so far, food disputes are more about cultural (or more precisely, culinary) differences than they are about protecting jobs and financial gains. We are aware of the growing emphasis on consuming organic foods, ranging from milk to eggs. In general, Europeans tend to be more concerned than Americans are about consuming genetically modified foods, partly because they are more skeptical of science.

An example of a dispute relating to food safety is Europe’s decision to ban imports of American beef produced from cattle that have been fed growth hormones. These hormones, used to accelerate beef production, are generally accepted by American consumers. However, Europeans, especially the extremely food-conscious French and Italians, prefer beef that has not been fed hormones. These cultural differences became the source for a trade dispute between Europe and the United States. Under global trade agreements, countries are allowed to ban imports of foods if there is scientific evidence to support concerns about safety. Americans argued that scientific evidence showed that beef hormones did not endanger human health. The WTO agreed with the United States and authorized the imposition of punitive tariffs of $117 million a year against European exports. Despite high tariffs on Danish ham, Italian tomatoes, and other European products, Europe refused to lift the ban, citing its own scientific findings that showed that high doses of hormones cause cancer.

Although human beings have engaged in genetic modifications for centuries, experiments conducted by Gregor Mendel with pea plants in his monastery garden in 1866 represented a breakthrough in this area and set the stage for more advanced genetic research. While advances in agricultural science have been embraced globally, the ability to transfer isolated genes into the DNA of another organism is widely viewed as a threat. The idea that a trait for cold resistance can be transferred from a fish to a plant has encountered resistance from environmentalists, consumers, and farmers in Europe and elsewhere. From the other perspective, genetically modified crops, developed by Monsanto, solve many problems that plague farmers, such

IS GENETICALLY MODIFIED FOOD A SOLUTION TO THE GROWING FOOD CRISIS? What are the costs and benefits of GM food? A Greenpeace activist holds up a cob of black corn during a demonstration in Mexico City aimed at keeping genetically modified crops such as corn from being planted in Mexico.

as pest control, soil preservation, and weed control. Most American farmers embrace genetically modified crops.

There was no sense of urgency in Europe to consume genetically modified crops. Environmental groups, such as Greenpeace, launched a global campaign against them, stressing not only the dangers they posed to consumers but also the dangers they posed to the natural environment. This campaign and others reinforced Europeans’ concerns about eating genetically modified foods. Public pressure influenced the European Parliament to enact a food-labeling law requiring merchants to clearly indicate if packaged foods contain any amount of genetically modified ingredients. Major food-importing countries, such as Japan and South Korea, also resisted consuming genetically modified crops. The United States, on the other hand, viewed Europe as using the genetically modified food issue to exclude American exports. Attitudes toward genetically modified crops are changing due to rapidly increasing food prices and growing food shortages around the world. 13

8.7: Global Trade and the Environment

1. 8.7 Recount the factors that have helped environmental issues become a concern in global trade

Many environmentalists, trade analysts, and antiglobalization activists believe that relentless competition in global trade inevitably leads to a disregard for environmental standards. Global trade advocates, on the other hand, tend to believe that economic globalization is instrumental in improving and safeguarding the global environment. Environmental protection is sometimes used as a barrier to free trade. A coalition of environmental, labor, and consumer groups mounted strong opposition to changing the U.S. policy of excluding Mexican trucks from operating in the United States. Their basic argument was that Mexican trucks were unable to comply with the higher American environmental standards and that they posed a serious threat to public health. Given the interest of labor groups in limiting competition from Mexican trucks, these environmental concerns could not be entirely separated from tangible economic interests. Growing competition from shrimp producers in developing countries was also a factor in the U.S. decision to use environmental laws—requiring shrimp nets to have turtle extruder devices to protect endangered turtles that are often caught in fishing nets—against shrimp exporters. The WTO ruled against the United States, viewing the application of the environmental laws as an illegal barrier to free trade.

Global trade creates many environmental problems. The sharp increase in the number of global factories has contributed to higher levels of pollution. The maquiladoras along the U.S.-Mexican border have increased pollution. China’s phenomenal economic growth is closely linked to widespread pollution. It is apparent to anyone visiting China that economic progress has contributed to the country’s environmental problems. The air and water in many of China’s major cities rank among the dirtiest and most dangerous in the world. China is the world’s largest consumer of coal as well as the world’s fastest-growing importer of petroleum. As an expanding middle class demands more energy for appliances, cars, and air conditioners, pollution will increase. Forest fires caused by the palm oil industry in Indonesia create health-threatening levels of pollution in Malaysia and Singapore. The growing use of cell phones, computers, and other electronic devices is creating electronic waste that is polluting many areas, especially developing countries that recycle them. Finally, global trade harms the environment by transporting invasive species. For example, zebra mussels from Europe, Pacific jellyfish, and the emerald ash borer from Asia cause significant damage in the United States and Canada.

8.7.1: Diseases and Global Trade

The speed of international travel and the expansion of free trade make diseases in almost any part of the world an immediate threat to other places. Many products purchased at the grocery store are imported. Economic globalization and global migration help to create global cities that are characterized by great ethnic diversity. Demographic changes have been accompanied by the proliferation of agricultural products available in grocery stores. At the same time, however, the relentless march toward reducing governments’ involvement in the economy has resulted in a smaller number of food inspectors. Furthermore, the globalization of many aspects of the food industry means that there is much mixing of products from different countries, which facilitates the spread of food-related diseases. An outbreak of foot-and-mouth disease in Britain in early 2001 illustrates the impact of diseases on global trade. The United States and Canada quickly banned imports of animals and animal products from the European Union. Similarly, an outbreak of bovine spongiform encephalopathy (BSE), commonly known as mad cow disease, in Britain in the same year demonstrates how global trade spreads diseases. The problem was soon discovered in countries that imported British cattle, beef, and animal feed. Because animal feed is globally traded like any other commodity, and it is mixed in with other feed, it is difficult to identify the source of many food-related diseases. In late December 2003, mad cow disease was discovered on a farm in Washington State. The impact on global markets was immediate. Japan, South Korea, Venezuela, and many other countries banned imports of beef and beef by-products from the United States. Contaminated pet food from China brought the problem of unsafe products to America’s attention. Furthermore, widespread use of lead paint on children’s toys made in China forced the United States to take action to inspect imported goods to a much greater extent.

8.8: Regional Trade Blocs

1. 8.8 Review the functionalities of different trade blocs

There are several reasons for the formation of regional trade blocs, which vary from one trade group to another:

1. Economic development: Many countries pool their resources and create larger markets by integrating their economies.

2. Managing trade regionally: Many countries regarded global trade institutions as too bureaucratic and slow in responding to both trade opportunities and trade problems.

3. Economic competition: Countries can become far more economically prosperous and enhance their ability to compete in the global market by forming trade blocs.

4. Political and strategic considerations: Many countries form trade blocs for political and security reasons. The European Union, for example, originated because of concerns about Germany’s aggression in both world wars.

Trade organizations range from free-trade areas to economic unions. We will briefly discuss the main types of regional trade groups, going from the most basic to the most complex.  Free-trade areas  are characterized by the removal of trade barriers among members. However, each country in the free-trade area maintains its own trade policies toward other countries, which often include significant trade barriers. Customs unions are free-trade areas that have a common external commercial and trade policy. Imports to the customs union are treated the same regardless of where they enter. This requires more cooperation and centralization of administrative tasks than in free-trade areas. The  Southern African Customs Union —formed in 1910 and composed of South Africa, Botswana, Lesotho, Swaziland, and Namibia—is the world’s oldest customs union. Common markets embrace the characteristics of free-trade areas and customs unions. They go further by providing for the free movement of people and capital, more harmonization of taxation and domestic policies, and more extensive administration. Finally, economic unions, which encompass all the features of common markets, represent the highest form of political and economic integration of sovereign countries. Besides the harmonization of government spending and taxation (fiscal policy), they have a central bank, a common currency, and numerous political institutions to achieve greater cohesion in foreign as well as internal affairs. The most powerful and recognized trade bloc is the European Union.

8.8.1: The European Union

As you travel through Europe, you see that the euro is the common currency in eighteen out of twenty-eight countries (with some notable exceptions being Sweden, Denmark, and Britain) and that passports are not required to cross national boundaries. In fact, common administrative regulations, the free movement of people across national boundaries, and the creation of numerous political, economic, and legal institutions are creating a stronger European identity. Stretching from Ireland and Britain in the west to Poland in the east and from Finland in the north to Cyprus in the south, the European Union is the most advanced trade bloc in the world. Beginning with the European Coal and Steel Community (a treaty signed in 1951 that came into effect in 1952), European integration evolved into the European Economic Community (EEC) or Common Market in 1957 with the signing of the Treaty of Rome. Two steps toward transforming the European Economic Community into the European Union in 1993 under the  Maastricht Treaty  of 1991 were, first, the establishment of the European Monetary System (EMS) in 1979 to stabilize monetary affairs in Western Europe and to safeguard against fluctuations in the value of the U.S. dollar, and, second, the signing of the  Single European Act  in 1986, which set the objective of building a unified European trade system by 1992. As we discussed in  Chapter 2 , European integration focused primarily on political objectives, despite the emphasis on trade. In an effort to create a union that would resemble the United States, European leaders created a constitution. The constitution provides for EU citizenship for nationals of member states, stresses the supremacy of EU law over those of member states, and designates certain areas (e.g., trade and foreign policy) over which the European Union will have full authority and other areas (e.g., justice, transportation, and economic and social policy) over which authority is to be shared between the European Union and the countries that belong to it. In an attempt to counter the power of the European Union, the United States, Canada, and Mexico formed the North American Free Trade Agreement (NAFTA).

8.8.2: The North American Free Trade Agreement

Unlike the European Union, which was formed primarily in response to the consequences of war,  NAFTA (the North American Free Trade Agreement) , is predominantly concerned with economic issues. Signed on November 18, 1993, NAFTA entered into force on January 1, 1994. It brought together three different economies, with the United States the dominant power, Canada in the middle, and Mexico on the bottom. These divergent levels of economic development motivated the United States, Canada, and Mexico to form the agreement. Mexico, burdened with debt, regarded a trade agreement with the United States as essential to achieving economic development. The United States desired to maintain stability in Mexico and saw abundant and inexpensive Mexican labor as beneficial to U.S. companies that were anxious to gain a competitive advantage over the Japanese and Europeans. Canada viewed economic integration in North America as a way of countering U.S. dominance of the Americas.

The level of integration among the United States, Canada, and Mexico differs significantly from that achieved by the European Union. NAFTA, unlike the European Union, does not provide for the free movement of people across borders. NAFTA countries pursue their own independent trade, foreign, domestic, and defense policies. Compared with the Europeans, who have given up some aspects of national sovereignty in exchange for European political and economic unification, NAFTA members jealously guard their sovereignty. Consequently, there are few institutions in NAFTA that are comparable to those in the European Union (e.g., the European Court of Justice, the Council of Ministers, the European Parliament, and the European Commission) that would diminish the autonomy of the United States, Canada, or Mexico. However, NAFTA has a significant supranational institution, the Free Trade Commission, which consists of cabinet-level officials or their designated representatives and is responsible for formulating policies dealing with trade. 14

8.8.3: The Association of Southeast Asian Nations

China’s rapid economic growth has helped focus increased attention on the  Association of Southeast Asian Nations (ASEAN) . Although we generally perceive Asia primarily in terms of its pivotal role in global trade and think of organizations such as ASEAN as trade blocs like the European Union, ASEAN’s origins were more strongly influenced by political and strategic considerations than by trade competition. The establishment of ASEAN in 1967 resulted primarily from the political and military concerns of Indonesia, Thailand, the Philippines, Malaysia, and Singapore. Southeast Asia had become ground zero in the Cold War. The United States, perceiving nationalist movements in Vietnam as part of the Soviet Union’s strategy to expand Communism throughout Asia, inexorably militarized the conflict in Vietnam. But while America’s policies in Vietnam are now regarded as having been seriously flawed, the threat of Communism was real to ASEAN. Only a united front against Communism could effectively counteract this threat.

Despite their obvious preoccupation with defeating Communism, ASEAN members emphasized that their organization’s purpose was to promote economic, cultural, and technological cooperation. As the Vietnam conflict receded, ASEAN membership expanded to include Brunei, Vietnam, Cambodia, Laos, and Burma. In 2003, China and India joined ASEAN’s Treaty of Amity and Cooperation, a nonaggression agreement designed to promote regional stability. They also agreed to collaborate in the fight against regional terrorism. But the focus has clearly shifted from traditional security issues to trade. ASEAN members believe that only through economic cooperation can they attract foreign investment and effectively compete with China. However, as China has become more assertive about its claims to the islands in the South China Sea, ASEAN is facing serious challenges. Furthermore, ASEAN members are also affected by competition between China and the United States for power in the Asia-Pacific region.

8.8.4: The South American Common Market

Latin Americans have made numerous attempts to integrate their economies to achieve economic development and to balance the economic and political power of the United States in the region. The formation of the  South American Common Market (Mercosur)  in 1991 represents a culmination of these efforts. Economic problems plaguing Latin America and economic, political, and border disputes impeded integration efforts. Furthermore, authoritarianism and military dictatorships throughout the region created such antagonism, competition, and distrust among the countries, especially Brazil and Argentina, that economic cooperation was virtually impossible. Not until these countries had resolved their economic and border disputes and had abandoned dictatorships and started to democratize were they able to begin integrating their economies.

Brazil and Argentina, the dominant countries in the region, were cognizant of growing economic regionalization and competition for investments and markets among trade blocs. They initiated the development of closer economic and political ties by signing the  Program for Integration and Economic Cooperation (PIEC)  in 1986. Given the economic competition between them, they decided to negotiate integrating specific sectors such as capital goods, food, iron and steel, and the automotive industry. This allowed them to diminish business losses in both countries and to consolidate industrial processes. This effort to open trade between Brazil and Argentina was consolidated by the signing of the Treaty of Integration, Cooperation, and Development in 1988. In 1991, Brazil, Argentina, Paraguay, and Uruguay signed the Treaty of Asunción, creating Mercosur. Bolivia, Peru, Chile, and Venezuela later joined the trade group as associate members. Barriers to trade among the members were removed; common external tariffs (against nonmembers) were adopted; and a commitment was made to coordinate trade, agricultural, industrial, fiscal, and monetary policies. In addition, they agreed to work toward harmonizing their domestic legislation to facilitate economic integration. In reality, trade among the members remains low, around 23 percent, and trade protectionist policies of various countries undermine Mercosur’s original commitment to economic integration.

Case Study Global Food Safety

Walk around in any grocery store anywhere in the world, and you will observe that there is food from many countries. We do not know the conditions under which the food was grown, processed, stored, and transported. We assume it is safe. The globalization of food has engendered complex food chains that are difficult to control. Individual governments face many challenges monitoring food safety, and companies generally have little control over their suppliers. Consumers are increasingly concerned about food safety, especially in light of numerous cases of the deliberate contamination and adulteration of food in China, a major food exporter.

As Americans consume more imported food, they are becoming more aware of problems with food safety. The U.S. government has responded by passing laws to increase inspections of food in the United States and in countries that export food to America. As we saw in  Chapter 7 , America is facing serious budget deficits, and the national debt continues to climb. Congress, reluctant to increase spending, agreed to cut spending across the board for all government programs, including food inspections. Budget reductions prevent the  Food and Drug Administration , which inspects all food except meat and poultry, and the Agriculture Department from inspecting foreign food factories regularly. Funding has been cut for border inspections of food coming through Canada and Mexico. Increased illness caused by imported food is directly linked to diminished U.S. government inspections. Only about 2.5 percent of food imports are inspected.

At the global level, the  International Food Safety Authorities Network  (INFOSAN) links national authorities responsible for managing food safety emergencies. It is a joint program of the World Health Organization (WHO) and the Food and Agricultural Organization (FAO), both bodies of the United Nations. WHO, through INFOSAN, assists counties with tracing products that contain contaminated ingredients and shares information on product names and production batches with them so that affected foods can be quickly identified and removed from the market. A major problem is determining which foods are contaminated by a particular ingredient. The complex global system of food distribution and the mixing of many ingredients make it extremely difficult to trace a contaminated ingredient.

Europeans were alarmed to discover that most beef products were contaminated with horse DNA and traces of an equine painkiller banned from the human food chain. While many Europeans consume horsemeat, the problem was fraud. Even though European rules require fresh beef to be labeled with the country of its origin, these rules do not apply to processed products. Furazolidine, a banned antibiotic known to be carcinogenic, was used in animal feed on hog and veal farms in the Netherlands and Germany. The meat was sold in the Netherlands, Germany, Belgium, France, and Italy.

Arsenic has been found in chicken and rice in the United States. A more serious food safety concern is the widespread use of antibiotics and other drugs in cattle, pigs, chickens, and turkeys. These drugs can result in drug-resistant bacterial infections in people. The widespread use of antibiotics in general has created bacteria that are resistant to them. An estimated twenty thousand people die and roughly two million become ill each year in the United States because of antibiotic-resistant bacteria. In response to growing health threats posed by antibiotic-resistant bacteria and pressure from American customers concerned about food safety, McDonald’s decided to phase out purchasing chickens raised with antibiotics. Walmart, the world’s largest retailer, followed suit when it announced in May 2015 that it is phasing out selling meat and egg products that are from animals that have been raised with antibiotics. At the same time, Walmart said it is asking its suppliers to use humane methods to raise animals. Many drugs used for animals in the United States are banned in Europe and Asia. This causes trade disputes between America and several countries that ban imports of American beef on safety grounds. Americans routinely face food poisoning from Salmonella outbreaks traced to imported food. Examples include Salmonella bacteria in Mexican papayas, Guatemalan cantaloupes, Turkish pine nuts, and Indian and Mexican spices and black pepper. Imported spices from India have also been contaminated with insect parts, whole insects, and rodent hairs.

China poses the greatest threat to global food safety. Excessive air, water, and soil pollution contaminate many areas where food is grown. Rice grown in Hunan Province, an area with many factories, mines, and smelters, has been contaminated with heavy metals such as cadmium, which causes cancer and other diseases. This problem is compounded by the use of illegal preservatives, additives, and pesticides. The deliberate contamination and adulteration of food is a great concern. Melamine in baby formula killed at least six infants and sickened almost a million. Rat meat has been sold as lamb; meat from dead and diseased animals is sold; chicken feet marinated in hydrogen peroxide and adulterated with additives are sold; and selling processed discarded cooking oil is a common practice. A Chinese supplier that produced food for Walmart in China sold Walmart donkey meat that was contaminated with dog meat. McDonald’s, KFC, Pizza Hut, and Starbucks had to withdraw meat products from their restaurants in China and Japan after discovering that their Chinese supplier, Shanghai Husi Food Company, had deliberately sold them expired and contaminated products.

America imports more than four billion pounds of a wide variety of foods from China yearly. These include canned tuna, mandarin oranges, fresh mushrooms, apple juice, tilapia, and frozen spinach. Chicken growers in the United States, Canada, and Chile ship poultry to China to be processed and shipped back to the United States to be used in pot pies, noodle soups, and other products. Consumers cannot determine where the chicken was processed. Labels are required only if frozen chicken parts are sold directly to consumers. Following an outbreak of avian flu, discussed in  Chapter 13 , that killed twenty-one million chickens and turkeys in the United States in 2015, several countries, including China and Mexico, restricted or banned imports of U.S. poultry and eggs.

Two large American ice cream companies recalled all of their products due to findings of Listeria bacteria in their products in 2015. Blue Bell Creameries of Texas was linked to ten Listeria illnesses in four states, including three deaths. The Jeni’s Splendid Ice Creams of Ohio recall was based on a finding of Listeria in a random sampling of ice cream, though there were no known illnesses.

People around the world want to know what they are eating. Americans influenced the government to ban trans fats, which cause heart disease. Kraft Foods, pressured by the Environmental Working Group and other food safety advocates, decided to remove artificial food dyes from its Original Kraft Macaroni and Cheese. Many want food containing genetically modified ingredients to be labeled. At least 70 percent of processed foods in America contain genetically modified ingredients. Unlike Europe, America has not banned genetically modified food. However, in April 2015, Chipotle was the first major U.S. restaurant chain to eliminate all genetically engineered ingredients from its food.

Summary

This chapter focused on the growth of and challenges to global trade and free trade as a way of increasing each country’s economic prosperity. It showed how trade is intricately linked to politics, economics, and culture. In an era of global trade and interdependence, we are seeing the power to formulate trade policies shift away from countries and national sovereignty toward MNCs. Accompanying this shift is another: a shift toward increased privatization of national industries and services and a smaller role for the state in providing social services and social welfare programs. Lower prices provided by companies such as Walmart, however, have been accompanied by an increase in corporate reliance on sweatshops that demand employees work long hours for relatively low pay. Such a “race to the bottom,” where corporations disregard labor protections and rights in pursuit of the cheapest bottom line, has been a main factor in the backlash against corporate globalization and free trade.

In this chapter, we also looked at the history of the globalization of free trade. As global trade became more important, we saw the development of various trade models distinguishing between the benefits of comparative and competitive advantage. In recent years, we have seen a trend toward increased liberalization in the transition toward free trade and global capitalism. In this transition, we witnessed the conflict between protectionist policies and state socialism and increasingly popular notions of free trade and corporate globalization. With the emergence of the Bretton Woods System after World War II, we saw a strengthening of free trade as promoted by organizations such as the World Bank, the IMF, GATT, and most recently, the WTO. Under the WTO, we have seen the growing importance of reducing trade barriers and protecting intellectual property rights as valuable components of global capitalism.

Discussion Questions

1. Discuss the causes and implications of insourcing.

2. Do you think that globalization contributes to improving living standards around the world? Give examples.

3. What are the premises and principles of GATT addressed in this chapter? Discuss the major trade disputes. Give examples.

4. What are intellectual property rights? Do intellectual property rights potentially violate principles of free trade? Please explain.

5. What factors discussed in this chapter have helped environmental issues become a concern in global trade?